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The RBA's rebalancing act rests on Fed action

Glenn Stevens' comments on Australia's terms of trade highlight the importance of a low exchange rate to the process of rebalancing the economy.

The governor flexed his muscles on the Australian dollar, but it is becoming increasingly evident that there will be little action on the domestic policy front until US budget negotiations resume in January.

Speaking at the Citi Investment Conference earlier today, RBA governor Glenn Stevens warned investors that the Australian dollar would fall. Stevens argued that the current exchange rate is not supported by Australia’s relative costs and productivity, and that the terms of trade would fall from here.

It was a clever communication trick from the governor, in a speech that otherwise reinforced many of the prevailing economic narratives. Sometimes the most powerful policy option available to the RBA is its communication. This morning Stevens made it known that the RBA has a different view of the exchange rate to the market. The market took stock of the comments, selling off the Australian dollar and driving it lower against the US dollar over the day.

The terms of trade is the key here. Despite the attention paid to the cash rate, the long-run driver of Australia’s exchange rate has always been the terms of trade. Slowing mining investment should see the Australian dollar come down. Nevertheless, the RBA will be hoping that the Fed begins to taper by March to put some downward pressure on the Australian dollar.

Whether this means that the RBA will help the process by reducing the cash rate again is debatable, though there is no doubt that the RBA recognises the importance of a low exchange rate to the process of rebalancing the Australian economy.

Make no mistake: this rebalancing is no small task. It is one thing to tighten monetary policy to create room for the mining boom, as the RBA have done on two occasions in the past decade. But it is a more difficult task again to rebalance the economy from one slowing sector to other relatively subdued sectors.

Stevens also commented on the housing sector, stating that he did not believe that the current rise in house prices was driven by credit growth. But he noted that this could change, acknowledging that it was important for banks to maintain strong lending standards, and that decisions must be made on sensible assumptions of future returns.

While the RBA collective wisdom may be that a housing bubble does not currently exist, the acknowledgement that it is concerned about maintaining credit standards should allow even the housing bears to rest a little easier. The RBA will likely be ready to act if loose monetary policy creates too much excitement.

Finally, the governor spoke in depth about the Abbott government’s decision to inject $8.8 billion into the RBA’s reserves. He noted that the increase will make it more likely that the regular flow of dividends to the Commonwealth will be resumed at a much earlier date than would otherwise have been the case. In other words, while the capital injection costs the federal government $8.8 billion now, this will be offset in the future by a continuation of RBA dividends that will help support the federal budget.

The governor did not say anything about inflation and, with monetary policy tentatively placed, it remains uncertain what or when the next move will be. I suspect a lot will be determined by whether the governor’s confidence in the exchange rate comes to fruition. If not, then I expect the rebalancing process might need some added help.

Perhaps the most interesting discussion of the morning session of the conference was during the speech by Citi’s Peter Orszag. Orszag, who was formerly director of the US Office of Management and Budget, provided some insight into the next round of debt ceiling negotiations.

Orszag said the political ramifications of the US government shutdown, including a dramatic decline in support for the Republicans and the Tea Party, make it increasingly unlikely that the next round of negotiations will be as dramatic.

With mid-term elections scheduled for the end of 2014, US politicians may prove unwilling to test the patience of voters with unnecessary theatrics. Ideology may give way, as politicians seek survival.

Orszag said that the Fed tapering of their asset repurchase program is intrinsically linked with the debt ceiling negotiations and any drama will result in a postponement of the taper until later in 2014. With each passing day, it is becoming increasingly likely that the RBA will be in a holding pattern until January, reluctantly at the mercy of the US political process.

Callam Pickering

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